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What will pop the
Internet bubble?
By Eric
Janszen • Bankrate.com
We started iTulip.com in November 1998, as a parody
of an Internet company. The premise? Excessive money growth in the
1990s resembles the 1920s, and brings to mind many such bubbles,
like Holland in the 1630s, when the famous tulipmania bloomed. Since
1996 growth in money supply has turned the U.S. stock market from
an investor's market into a speculator's market. Silly, ill-conceived
and uneconomical Internet companies funded by public capital define
this particular asset bubble. And it's this phenomenon we ridicule
to make our point.
Last year, most visitors to the iTulip.com
site were either unaware of the asset bubble or didn't believe it.
This year, one Internet company IPO after another garners mammoth
publicity, each dot-com more absurdly valued than its predecessor.
The public has gradually come to accept the bubble, like a middle-aged
person accepting an infirmity -- a harmless annoyance. Even the
mania participants now accept that they are part of a mania.
This acceptance is an element of all manias. During
the final stages, the mania participants finally admit that they
are in a mania. But they rationalize that it's OK because they --
only they and not the other participants -- will get out in time.
Of course, they are wrong. Only the few with the luck to time their
short positions will make out when a mania ends.
So what causes a market bubble to pop and what will
pop this one? Historically, four kinds of events deflate an asset
bubble.
Credit Squeeze
Usually caused by sudden central bank tightening,
a credit squeeze can induce a market crash. Sometimes credit is
squeezed on purpose to slow or reverse market speculation. After
all, it's the Fed's job to keep the money supply within limits to
prevent inflation. The Fed keeps an eye on real estate prices and
will thwart speculation in that market with little hesitation. But
the Fed seems completely dense when it comes to speculation in the
stock market, totally confused about how much share price to attribute
to realistic expectations of future earnings and how much to speculation.
Sudden central bank rate hikes are blamed for inducing
the crashes in 1929 and 1987 in the U.S. and in 1989 in Japan. But
just as often the credit squeeze that crashes the market is caused
by what economists call a "random exogenous event," such as a major
credit default (Russian bonds last year), or the collapse of a big
bad bet (the "can't-miss" Long-Term Capital Management hedge fund).
Fed chief Alan Greenspan has proven to be a gradualist
-- no sudden big rate moves -- so his clearly foreshadowed mini-rate
hikes are not likely to cause the current U.S. bubble to pop, at
least not right away. But here's a possibility. Markets take about
a month to respond negatively to a rate hike. The real economy takes
about six months to respond to a rate hike. So two small rate hikes
spaced five months apart can cause as severe reaction in the market
as a single major rate hike. Thus, the .25 hikes in July 1999 and
November 1999 may cause as significant a market reaction in December
1999 as a surprise .5 hike.
Bankruptcy
A market leader goes bottoms up. If Amazon.com, for
example, were to run out of money -- not too far fetched since Amazon
spends much more than it earns and may not be able to raise more
funds by selling more stock or taking on more debt, the company
may need to file for bankruptcy. Investors will likely storm for
the exits to sell Amazon.com and just about every other company
with a similar money-losing business model -- i.e., most dot.coms.
Fraud
A market leader is revealed to have engaged in unlawful
business practices. The effect is similar to a bankruptcy. Investors
lose confidence in all similar investments as a class, panic, then
race for the exits. In September, SEC Chairman Arthur Levitt woke
up from his regulatory slumber to publicly call into question the
"dysfunctional relationship" between analysts and the investment
banks that employ them. Among other self-imposed reforms, he'd like
to see analysts use the "S" word (Sell) at least occasionally. (Analysts
rate stocks from 1-5, or strong buy, buy, hold, sell and strong
sell. In truth, they only haul out a "sell" or "strong sell" recommendation
about 3 percent of the time.)
The message to the investment banking community is
clear: fix it or I'll fix it for you. Last week a sub-committee
of the SEC announced that it is reviewing 20 questionable accounting
practices used by Internet companies, including the accounting of
barter as revenue. The ruling has been put off until January.
What woke Arthur up? Rumor has it that the international
banking community is starting to make noises about U.S. accounting
practices. The U.S. is supposed to lead the world in following transparent
and strict accounting rules, but the behavior of some corporations,
investment banks and securities firms calls this into question.
It also opens a can of worms. For example, what if
the SEC decides that stock options are an expense? As Warren Buffett
said recently, "If stock options are not an expense, what are they?"
Good question. What if the SEC decides that corporations cannot
improve their profit numbers by paying employees currency it creates
in lieu of cash, currency that it does not have to account for as
an expense? Any new regulatory activity raises the possibility that
the bubble will get regulated away.
Weakness in the Real Economy
Let's say a few economic numbers come out in December
that suggest that the economy is slowing. This suddenly reveals
to investors that their investments are based on earnings growth
that the economy will not support -- stocks are overpriced. Since
the data appears to come from nowhere, again investors will tend
to sell in a panic.
Name that pin
If I were to guess which is most likely to pop this
bubble, I'd say No. 1, a credit squeeze in late November or early
December as a result of previous Fed tightening. But I expect that
all four pinpricks will come into play. The credit squeeze will
be followed by a bankruptcy, since dot coms may not be able to compensate
for the lack or profits by raising or borrowing more money.
How about fraud? If this mania is like every other,
the smell of easy money has attracted a lot of shady characters
and motivated unseemly behavior among the otherwise ethical and
lawful. Don't be surprised if the management of a few Internet favorites
turns out to have cut a few legal corners. Finally, since so much
consumer spending is done due to the addition of stock market "wealth"
on the family balance sheet, expect consumer spending to drop fast,
slowing the economy.
So what happens if the bubble pops? The Fed will of
course pump up the cash supply again -- "flood the streets with
money" as a previous Fed chairman was fond of saying -- as in late
1998 and the early part of 1999. And the bubble picks up where it
left off, growing to the next stage of outrageous proportion. As
scary as that is, the alternative is worse. If the new liquidity
doesn't re-inflate the markets, we crash hard. The result of that
unlikely event is a topic for another day.
Posted -- Nov. 29, 1999
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